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Fed Asks 30 Banks to Undertake Stress Tests for Rising Unemployment

Blog Jan 15, 2013

The Federal Reserve has asked 30 big banks to test their ability to withstand a deep depression wherein the unemployment rate could rise to 12%. Aiming to ensure that the banks have enough funds to continue operations during tough economic times, the Fed has laid out three criteria for testing.

The Federal Reserve has stated that it is not making an economic forecast but outlining hypothetical situations aimed at assessing the strength of the country’s financial institutions. Apart from considering a high unemployment rate of 12%, which compares with the 7.9% level recorded in October 2012, banks also need to evaluate their strength in a situation where the real GDP declines by around 5%, The adequacy of capital buffers of the various banks needs to be tested, the Fed has said. The third criteria which the banks needs to consider is a scenario wherein the equity prices will fall by more than 50% and house and commercial real estate prices declining by around 20% each.

The banks were first asked to conduct stress tests in 2009. Although the latest test conditions laid out by Fed are harsh, they are not as bad as the actual scenario during the Great Recession from late 2007 to 2009. During that period the unemployment rate increased from a level of 4.7% before the start of recession in November 2007 to a high of 10%. The US economy had also shrunk by 8.9% in one quarter with home prices declining sharply by 33% from their peak levels.

These 30 institutions have been asked to submit their capital plans to the Federal Reserve by January 7.  The review of 30 banks is a result of failure of several banks including Ally Financial Inc, Citigroup Inc, MetLife Inc and SunTrust Banks to have adequate capital according to a stress test conducted on 19 big banks in March 2012. The exit of Vikram Pandit from Citigroup Inc was attributed to the disappointing results of the stress tests.

Of the various largest banks under review by the Federal Reserve, 19 have already hiked their common capital to $803 billion in the second quarter of 2012 from $420 billion in the first quarter of 2009.

The results of the stress tests will help the Federal Reserve take decisions relating to allowing banks to issue dividends or announce stock buybacks. The banks are required under this review process to inform the Fed about what dividends and stock buybacks they wish to issue. These proposals can also be modified during discussions about the stress tests with the central bank.

Apart from the Federal Reserve, the Federal Deposit Insurance Corp and the Office of the Comptroller of the Currency have also decided to conduct stress tests on some large institutions under their purview. Consequently more than 100 large financial institutions having a capital of more than $10 billion each will conduct stress tests to test their ability to withstand tough times. However, community banks having assets less than $10 billion are not required to conduct such stress tests.

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Lynette Zang

Chief Market Analyst, ITM Trading

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